Letter to Investors - April 2002

 

 

The Breadth of The Bear

 

A Secular Bear

            As we pass into the second quarter of 2002, the bear market that represents so much pain to so many people is officially now two years old. As you can see in the chart below, the various market indices dropped between 12% and 64% over that two year period. While one cannot invest directly in any index, they do represent a way of seeing what has happened to the immediate price levels of the publicly held corporations in America. Looking back over those 24 months, the picture is anything but pretty. Not only did we see the indices decline as much as any of us have seen in our lifetimes, but the “recovery” has been more painful and extended than anything we have seen since the mid-70’s.

            In many ways, the breadth (length) of this bear market is even more distressing to many people than the depths to which it plunged. Those of you who have gone with me through the laborious process of establishing a financial plan will recognize what is happening here. This is a Red Circle (see the chart on page 4). Not only is this a bear market, it is the version of bear we who study such things call a Secular Bear.

            Growing up in the mountains of Southeastern Oklahoma (Yes, there are mountains in Southeastern Oklahoma, check your map.), any meat we had on the table was something we had killed. Most of that meat was something we hunted in the forests that covered those mountains in the days before clear-cutting. One of the hazards of moving quietly through those mountains was the danger of coming upon a bear. A bear tearing at a rotted log or raiding a wild bees’ nest is in a position of not being able to hear very well. Since, as a hunter, I would normally be moving quietly up-wind, I was ideally positioned to surprise the bear.

            The important thing here was not if I encountered a bear, but when. I could have chosen the response of not hunting, which would have meant not having that meat on the table, or walking through the forest making noise - the recommended method of not surprising a bear. Neither of those was acceptable. To effectively hunt, I needed to simply recognize that I was going to encounter a bear, and probably when I least expected it!

            On one occasion, I encountered a bear because I was intent on following the sound of bees. Since bees tend to make their nests in hollow trees up high, I was walking along quietly (in case there was game in the area) with my head tilted back searching the tree trunks. The bear was doing pretty much the same thing. Deeply focused on the high tree trunks, I heard a sound that froze me in place with chills running up and down my spine, “Whuff!?” Bears make sounds that strongly indicate their attitude. In this case, the “Whuff!?” meant I was in the immediate vicinity of a bear who was surprised, curious and unsure of what to do.

            Here is where being prepared for the bear was a good idea. My immediate instinct after freezing was to run. If you know nothing about bears, that might sound like a good idea. Actually, it works quite well for another animal that was to be found in those forests and was even more dangerous; the wild razorback hogs. The dangerous hogs were the sows with pigs. By running from the hog, one also distanced oneself from the pigs and since mamma hog was only concerned about those pigs, it was an excellent idea to run.

            Bears are different from pigs. For whatever perverse reason, running from a bear is an almost sure fire way to start a foot race. The French refer to running at full tilt as “running with all your legs.” In this case, French describes the outcome better than English. The bear has four legs when running; humans have only two. In a foot race through the woods, the bear always wins. Another oddity about bears is that they believe the winner of a foot race is entitled to eat the loser.

            Running from a bear is a bad idea. I already knew that. I had heard tales of what happened to folks that ran from bears. Still, every muscle in my body was ready and willing to run! It took all my will power to muster up the courage to simply stand there, spread out my arms to look bigger and bellow out what I had been taught, “YO BEAR! WOOO-EEE! YO BEAR! WOO-EEE!” and to keep yelling until the bear turned and started away. I have no idea to this day whether or not that methodology would be approved of by a park ranger, but my grandfather, Thomas Jefferson Hadley, who qualified as the master hunter of the family, had told all of us time and time again that bellowing those words would cause the bear to leave us alone. He also said that the thing to do as the bear began to depart was never to give in to panic and turn our backs on the bear, for the bear would turn around to see what we were doing, and if we were running away, the foot race would start.

            Sure enough, the bear perked up as I began to bellow. It stood up on its hind legs and got a good look at the strange apparition in front of it, bellowing and flapping like a crazy bird, then dropped to all fours and ambled away. I stopped bellowing and, again against all instinct, stood watching the bear. After the longest maybe twenty seconds in my life, the bear did exactly what my grandfather had said; it turned around and started back toward me. Once again I went into the flapping and bellowing act. At my first bellow, the bear stopped like it had hit a wall with a loud “WHOOF!” This “WHOOF!” had no question mark attached at the end. It was clear the bear was now unhappy with whatever was in front of it and was no longer the least bit curious, but the bear did not growl, just “WHOOF!” Once again it turned around and ambled away. After watching the bear as it slowly disappeared into the forest, I sat down on the ground and took some deep breaths for a while as I thought about my grandfather’s wisdom.

            Thomas Hadley had grown up and hunted in those woods all his life. He was the grandson of a Civil War Veteran who was one of the first white settlers in that area. He had the wisdom of many generations of wood lore to draw upon. He knew that, unless I was between a momma bear and her cubs, the only reason a bear would attack me was because it was curious. Bears did that to large objects they were curious about. The methodology was for the bear to knock it around a little, bite on it some to see if it was good to eat, then knock it around a little more. If it did not come apart and reveal something good to eat, like the insects inside a rotted log, the bear would quickly bore of the game and leave, unless, of course, the thing decided to put up a fight. In that case the bear would be obliged to defend itself. He often pointed out that, “Bear thinkin’ is differ’nt from the way people think.”

            He acknowledged that rolling up into a ball and playing dead was the thing to do if the situation reached the knocking around and biting stage, but well before that the thing to do was to irritate the bear without threatening it. Bears, he said, do not like loud noises. They also do not like things that flap around. Most of the time, bears have pretty much a one track mind. They are looking for something good to eat. Anytime they find something about the size and shape of a stump or log, they will knock it around and bite on it, hoping for grubs. If they see something big and upright (like a human), they will make a decision whether it is another bear or a log or fits into the general category of “something else.” Things that look and act like logs will get treated like logs. Things that are upright and run away will be treated like another bear. Since bears are territorial, other bears need to be taught a lesson about trespassing.

            My grandfather’s logic was that bears and birds get along pretty well. Bears ignore birds as big as a blue heron standing nearly six feet tall when perched on a stump or riverbank. When a heron starts squawking and flapping as a bear approaches its chicks, the bear simply turns and leaves because it finds the noise and all the movement uncomfortable. The most important thing though was don’t panic, don’t try to run away! He would emphasize that the only people who got mauled by a bear were folks who either got between a sow bear and her cubs or tried to run away.

 Dealing With the Bear

            My grandfather’s advice was good then and it is now. Being the imaginative person that I was and am, I asked him one time what we were supposed to do if the bear did not go away immediately. He said the smartest thing to do under most circumstances was nothing. He said if the bear was not paying any attention to us, we should not pay too much attention to the bear. He suggested that if we were hunting squirrel we should continue moving on as if the bear were not there. Obviously, if that meant walking right into the bear, then a short detour would be in order, but otherwise just keep on. Some bears, he said, were apparently quite used to humans and unless the human ran away or attacked, the bear would probably leave of its own accord in its own good time. He noted that if the bear stayed around, it was because the bear had something it believed it needed to do and it would stay there until it finished. Typically that meant the bear had found a rotten log and was tearing it apart to get to the grubs and worms inside.

            Today, we find ourselves faced with a bear. For many of us, this is not the first bear we have faced. It is, however, one of the biggest and it is wandering around and showing little interest in going away. It, in short, is a Secular Bear.  Secular bears are different from Cyclical Bears. Cyclical bears are like the one I encountered hunting honey. I believe that simply not panicking and being assertive for a short time will bring us through them. Secular Bears are in the business of changing things. Secular Bears eat companies. Enron and Arthur Anderson & Co. apparently are rotten logs with lots of worms and insects inside that need to be exposed to the light of day. I read in the Wall Street Journal that the bear is beginning to knock Merrill Lynch and Co. about now. The Attorney General of New York is claiming (to use my analogy) that there are grubs inside that log, although the log is protesting, “That just ain’t so.”

            Most of us think of the market as our friend. We believe, or at least used to believe, that the economy of the United States, as reflected in the “market” would bring us to prosperity. Suddenly, we found our old friend, the market, wasn’t just going “Whuff!?” Instead, it was snarling and growling and is now ripping up rotten logs and anyone who runs away.

            This bear is acting just as bears act. You will notice from the graph below, the bear, after getting quite close around the end of September, or the third quarter of 2001, moved up, or away, for the forth quarter and now seems almost to be coming back again. It is not interested in destroying you, unless, of course, you run away. On the other hand, it would not be a good idea to confront the bear by attempting to load up on whatever the bear is destroying. In this case, I believe my grandfather’s wisdom about bears that do not go away quickly applies. We simply need to keep on doing whatever we had set out to do in the first place.

            That does not mean waltzing right into the mouth of the bear though. If you, for example, were involved in a systematic withdrawal from your portfolio based on the market values you had back at the end of the first quarter 2000, at the top, rethinking your strategy may be an excellent idea. It also may be that looking at your portfolio reveals you are far too heavily invested in one or a few sectors of the economy. Again, rethinking your strategy is a good idea. On the other hand if you had a well thought out and well-diversified portfolio when you were surprised by the bear, odds are it is still a well diversified and rational portfolio. Reexamining your portfolio every few years is a good idea in any case.

            The great difficulty in a bear market is similar to the one we face in the throes of a major bull market. Both distort returns so much that it is difficult to tell whether your portfolio is good or bad. I coined a phrase a few years ago that seems to have a lot of value today, “Bull markets make geniuses of all of us, but a Bear shows us for the fools we really are.”  You may well have seen a five-year trailing return in your portfolio around the beginning of 2000 that ran as high as 20% per year. Today you may be looking at a five-year trailing return in the single digits. Which is right?

            The answer (as you probably guessed) is neither. Had you looked carefully at the five-year average annual rate of return of the S&P 500 Stock Index, probably the most well known broad measure of market values, at the beginning of the year 2000 you would have noted that it had averaged a whopping 25.37% per year from the beginning of 1995 until the beginning of 2000. To assume that was the norm into the future was a common but dangerous mistake. Today, two years into our encounter with the bear, the five-year trailing average annual rate of return of the same index is 8.45%.

            It is only when we look back ten years or more that things seem to stabilize. The current return of the S&P 500 for the ten years ending in 2001 is 12.61%. If we really crane our necks and look back fifty years, we find that the average annual rate of return is almost exactly 12%. Now here’s where it gets interesting. The fifteen-year return is 14.4% per year, the twenty- year return is 14.2% per year, and the twenty-five year return is 14.1% per year!

 

Now, before I go any further, that is the past and not the future, but the consistency of that return in the 15, 20, and 25-year periods is pretty amazing. Even if we go back to 1971, just before the last secular bear, our average annual rate of return through 2001 is 12.3%.

            The next issue to consider is whether that long-term trend will continue. If we presume that the United States has not gotten worse in the last twenty years, that the productivity has increased (it has), that the educational level has risen substantially (it has) and that the overall operational management of companies has improved dramatically (it has), then it would be a reasonable assumption that the valuation of those companies on the open market would continue to rise at a rate equal to or greater than it has in the past. If we make those assumptions, then the trend line shown above should be the norm. Given all those assumptions, that means the broad valuation of American companies as measured by the S&P 500 is below the norm, or fair market value.

            Of course, one could make the argument that we are once again in the 1970s, when we saw the last secular bear. The difference between then and now seems to me to be rather substantial. Back then, we were losing a war in Vietnam, enduring a Presidential scandal that resulted in the resignation of the President and indictment of the Vice President, and suffering through a four-fold increase in the price of oil, all while adapting to double digit inflation and automobiles that fell apart three years from purchase.

            The future holds no guarantees. We are engaged in a war that well may determine the fate of Western Civilization. We often seem to be standing alone in that war. We have been wracked with angst at the misdeeds of perhaps one of the most trusted firms in America, Arthur Anderson & Co., and seem to find another example of either excess or outright chicanery in corporate America every day. But, let us not forget our blessings. We are led by perhaps the most capable administration in the history of our country. The level of unemployment is still at a low undreamed of by previous generations. Our standard of living is not only the highest in the history of the world, but it is still moving upward and lifting thousands of families out of poverty each day.

Perhaps most importantly, the United States of America is the seat of the vast, vast, majority of inventing, innovating, and productivity improvement in the world. We are a nation supremely confident in who we are and convinced that what we are doing works, simply because it does!

            Presuming you are well diversified across this amazing economy and your diversification is being managed by firms and people who have proven themselves to be worthy of your faith and further that you do not have all your investments being managed by one company, what you are actually investing in is the United States Economy, rather than individual issues. From my humble point of view, I cannot think of a better time to own a piece of this, the greatest economy in the history of the world.

 Facing The Bear

             Bears have a purpose. They clear out the dead wood logs and knock down the rotted trees. Lumber companies came along and began to “farm” the forest, eliminating the great variety of tree types and most certainly the bears. Without the great variety and the willing assistance of the bears, corruption spread and wiped out much of the timber forests of Eastern Texas and Oklahoma. Much money and effort is now being expended to find a way to stop that timber disease. Without the bear in our marketplace, we would eventually go the way of the forest. The Soviets ironically outlawed bear markets, only to have corruption swallow up their economy.

            If we follow my grandfather’s advice and have the patience and courage to just keep on as the bear deals with what the bear needs to deal with, we will have the opportunity to profit from the bear’s work. Patience and courage are perhaps the most underrated and yet among the most powerful virtues in this life. As hard as it is to look upon the reduced price reflected in our statements, all the alternatives are only worse. Let us continue with patience and faith on the path that has brought us this far. Believe it or not, the bear is our friend!

 

Jeffrey W. McClure                                                                                               Certified Financial Planner™

 P.S. Thinking back over the decades during which I have been advising folks about investments, I have distilled some points that are, from my point of view, an expression of reality. Disappointments come when we have a picture of reality that isn’t real, so these points may very well save you some serious disappointments down the road. 

Some Truths About Equities:

1.       Over the last two centuries U.S. stocks, as a class of assets, have dramatically outperformed bonds, savings accounts, precious metals, and even real estate.

2.       At times, generally separated by about 30 years but possible to occur at any moment, the short term value of equities have dropped 50% or more, and have historically normal declines more often of around 30%.

3.       To obtain a return on invested money greater than zero after taxes and inflation, one must be willing to accept short-term declines in market price that get much larger as a higher rate of return is sought.

4.       Historically, the longer one holds a diversified portfolio of equities, the higher the probability of a positive return above that of savings positions. Conversely, the longer one holds a savings position, the lower the real return (after taxes and inflation) and the higher the probability of a loss.

(Research and raw data obtained from Stocks for the Long Run by Jeremy J. Seigel, McGraw Hill, 1998, and Stocks, Bonds, Bills, and Inflation, Ibbotson Associates, 2002.)

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